Production possibilities frontier (PPF)

A curve showing all combinations of two goods that can be produced

• Society’s choices
– Points inside or on PPF
• Unattainable
– Points outside PPF
• Productively inefficient
– More of at least one good can be produced
• Without sacrificing the production of any other good
– Points inside the PPF
• Productive efficiency
– The absence of any productive inefficiency
• Economic system
– The way our economy is organized
• Features of economic systems
– Specialization
• Method of production in which each person concentrates on a limited number
of activities
– Exchange
• The act of trading with others to obtain what we desire
• Specialization and exchange
– Enable us to enjoy greater production and higher living standards
• Than would otherwise be possible
• Gains from specialization and exchange
– Development of expertise
• Become experts at one or two things, instead of remaining amateurs at a lot of
things
– Minimizing downtime
• Less unproductive “downtime” from switching activities
– Comparative advantage
 • Allocate our resources according to their suitability for different types of
production
• Absolute advantage
– Produce a good or service using fewer resources than other producers use
• Comparative advantage
– Produce a good or service at a lower opportunity cost than other producers
• Traditional economy
– Resource allocation - long-lived practices from the past
• Command or centrally planned economy
– Resource allocation - explicit instructions from a central authority
• Market economy
– Resources are allocated through individual decision making
• Market
– A group of buyers and sellers with the potential to trade with each other
– Global - buyers and sellers who are spread across the globe
– Major role in allocating resources
• Price
Amount of money that must be paid to a seller to obtain a good or service
• Opportunity cost
– Total sacrifice needed to buy the good
• Adam Smith (1723–1790)
– The Wealth of Nations, 1776
– The Wealth of Nations, 1776
• Supply and demand
– Economic model, designed to explain how prices are determined in certain types of
markets
• Prices
– Important role in the economy
– Which households will get which goods and services
• Market
– Group of buyers and sellers with the potential to trade with each other
• Macroeconomics
– Broadly defined markets
• Microeconomics
– More narrowly defined markets
• Aggregation
– Combining distinct things into a single whole
• Circular flow
– Simple model that shows how goods, resources, and dollar payments flow between
households and firms
• Product markets
– Markets in which firms sell goods and services to households
• Resource markets
– Markets in which households that own resources sell them to firms
• Imperfectly competitive market
– Individual buyers or sellers can control or influence the price of the product
• Perfectly competitive market
– No buyer or seller has the power to influence the price
• Law of demand
– When the price of a good rises, the quantity of the good demanded will fall, ceteris
paribus
• Ceteris paribus
– Latin for “all else remaining the same”
• Demand schedule
– A list: quantities of a good that consumers would choose to purchase at different prices,
ceteris paribus
• Demand curve
– Graph of a demand schedule
– Curve showing the quantity of a good or service demanded at various prices, ceteris
paribus
• Movement along the demand curve
– Caused by a change in price
•
 • Shift of the demand curve
– Caused by a change in any variable that affects demand
Factors That Shift the Demand Curve
1. Income
– The amount that a person or firm earns over a particular period
• Normal good
– A good that people demand more of as their income rises
• Inferior good
– A good that people demand less of as their income rises
2. Wealth
– Total value of everything a person/firm owns
3. Prices of related goods
– Substitutes
– Complements
– Substitutes
– A good that can be used in place of some other good
– Complements
– A good that is used together with some other good
4. Increase in population
– Increase in demand
5. Expected price
– An expectation that price will rise in the future
6. Tastes or preferences
– Tastes change towards a good
• Increase in demand
7. Other shift variables
– Government subsidies
– Demand for goods
– Law of supply
– As the price of a good increases, the quantity supplied increases
 – Supply schedule
– A list: quantities of a good or service that firms would choose to produce and sell at
different prices, ceteris paribus
– Supply curve
– A graph of a supply schedule
– Quantity of a good or service supplied at various prices, ceteris paribus
– Upward sloping
– Shift of the supply curve
– Caused by a change in any variable that affects supply
– Rightward shift: increase in supply
– Leftward shift: decrease in supply
– Change in quantity supplied
– A movement along a supply curve
– In response to a change in price
– Change in supply
– A shift of a supply curve
Factors that Shift the Supply Curve

1. Input prices
– A fall in the price of an input
• Increase in supply: rightward shift
– An increase in the price of an input
• Decrease in supply: leftward shift
2. Price of alternatives
• Alternate goods
– Other goods that firms in a market could produce instead of the good in question
• Alternate market
– A market other than the one being analyzed in which the same good could be sold
3. Technological advance in production
– A firm can produce a given level of output in a new and cheaper way than before
– Increase the supply of a good
4. Increase in the number of firms
– Increase the supply
5. Expected price
– An expectation of a future price rise
• Shifts the current supply curve leftward
– An expectation of a future price drop
• Shifts the current supply curve rightward
6. Weather and other natural events
– Favorable weather: increases crop yields
• Rightward shift of the supply curve for that crop
– Unfavorable weather: destroys crops
• Shifts the supply curve leftward
– Natural disasters
• Destroy/disrupt productive capacity
7. Other shift variables
– Government tax

– Equilibrium price
– Market price that, once achieved, remains constant until either the demand curve or
supply curve shifts
– Equilibrium quantity
– Market quantity bought and sold per period
– Price below the equilibrium price
– Excess demand
– Excess demand - at a given price
– Amount by which quantity demanded exceeds quantity supplied
– Price above the equilibrium price
– Excess supply
– Excess supply - at a given price
– Amount by which quantity supplied exceeds quantity demanded
 – Equilibrium
– Crossing point between the demand curve and the supply curve
– Equilibrium price: vertical axis
– Equilibrium quantity: horizontal axis
– Increase in demand
– Rightward shift of the demand curve
– Rightward movement along the supply curve
– Decrease in supply
– Leftward shift of the supply curve
Leftward movement along the demand curve

Working with Supply and Demand

• Governments
– Sometimes intervene to change the market outcome
– Fight the market
• Prevent the price from reaching equilibrium value
– Price ceilings
– Price floors
– Manipulate markets
• Changing the equilibrium itself
• Price ceiling
– Government-imposed maximum price in a market
• Short side of the market
– The smaller of quantity supplied and quantity demanded at a particular price
• When QD and QS differ
– The short side of the market will prevail
• Shortage
– Excess demand not eliminated by a rise in price
 – QD > QS
• Price ceiling: creates a shortage
– Increases the time and trouble required to buy the good
– Price decreases
• Black market
– A market in which goods are sold illegally at a price above the legal ceiling
– Price: above equilibrium price
• Rent control
– Price ceiling imposed in a rental housing market
– Government-imposed maximum rents on apartments and homes
– Purpose: to keep housing affordable
• Price floor
– Government-imposed minimum price in a market
– Purpose: to help sellers
• Surplus
– Excess supply not eliminated by a fall in price
– QS > Q D
• Price floor
– Surplus of a good
– Temptation: to sell the surplus below the price floor
• Critics
– Government spends too much money buying surplus agricultural products
– Higher prices distort the public’s buying and eating habits
• Excise tax
– A tax on a specific good or service
– Can be collected from either sellers or buyers
• Tax incidence
– The division of a tax payment between buyers and sellers
• Tax shifting
– Some/all of a tax imposed on one side of a market
 – Ends up being paid by the other side of the market
• Excise tax on sellers
– Shifts the supply curve upward by the amount of the tax
– Incidence: both sides of the market
Buyers pay more and sellers receive less
• Excise tax on buyers
– Shifts the demand curve downward by the amount of the tax
– Tax incidence – both sides of the market
• Buyers pay more
• Sellers receive less
• Tax incidence
– Distribution of tax burden between buyers and sellers
• Tax incidence vs. tax collection
– The tax incidence is the same whether the tax is collected from buyers or sellers
• Subsidy
– A government payment to buyers or sellers on each unit purchased or sold
• Medical care for the poor and elderly
• Energy-saving equipment
• Smoking-cessation programs
• College education
• Subsidy to buyers
– Shifts the demand curve upward by the amount of the subsidy
– Benefits both sides of a market
• Buyers pay less
• Sellers receive more for each unit sold
• Subsidy to sellers
– Shifts the supply curve downward by the amount of the subsidy
Benefits both sides of a market
• Distribution of benefits from a subsidy
Are the same, regardless of whether the subsidy is paid to buyers or sellers